- Greek voters rejected the terms of an international financial aid package on Sunday, with a “no” vote in excess of 60%. Meanwhile, opinion polls show that membership in the eurozone continues to be supported by a large majority of the Greek population.
- The Greek government told the electorate that a “no” vote did not amount to an exit from the eurozone, but would allow the government to negotiate a better deal with its creditors — led by the European Union, the European Central Bank (ECB) and the International Monetary Fund (IMF).
- This is a short-term victory for the Greek government, which actively campaigned for a “no” vote, arguing that the austerity measures being imposed by lenders in return for financial aid were onerous and would further harm Greece’s beleaguered economy. However, from the vantage point of the creditors, the “no” vote was a rejection of structural reforms and fiscal discipline that they have demanded from Greece.
- Since the referendum, equity, bond and currency markets have experienced some volatility, although market reaction thus far has been more muted than many investors expected. At present, there are many unknowns; near-term volatility is likely to remain elevated as negotiations continue among European policymakers, creditors and Greek officials.
What Could Happen Next?
- There is no clear-cut answer to how the situation will unfold. However, markets have had time to prepare for Greece’s exit from the eurozone, should that occur. The ECB has pledged to do whatever it takes to avoid contagion to other southern European countries such as Portugal, Spain and Italy.
- In the view of our economists, Europe will now have to come up with a new plan. One option would be to modify the current financial aid package so that the basic pillars — namely structural reforms and fiscal discipline — remain the same, but the amount of fiscal flexibility is adjusted at the margin.
- Lenders will also likely have to sweeten the deal with some type of implicit debt relief. This was reinforced by the IMF’s explicit call for debt relief last week. That said, it is not clear what combination of debt relief and fiscal austerity is acceptable politically to Northern Europe as well as Greece.
- Greek Prime Minister Alexis Tsipras continues to underscore the country’s desire to remain part of the eurozone. In a somewhat surprising move, Finance Minister Yanis Varoufakis stepped down as a concession to the creditors who viewed his presence as an impediment to a deal. He has been replaced by Euclid Tsakalotos, alternate foreign minister and an economist who has been representing Greece in bailout negotiations since April.
- Thus far, the European Central Bank has continued to provide liquidity support to Greek banks while political discussions are underway. However, the longer the uncertainty around Greece persists, the greater will be the impact on the European recovery. The ECB is also now more likely to expand and extend its quantitative easing program.
How Long Does Greece Have to Come to an Agreement?
- On July 20, €3.5 billion in Greek sovereign bonds held by the ECB and other national central banks will mature. If Greece defaults on that payment, it would be very difficult for the ECB to continue accepting collateral from Greek banks, and the €89 billion in Emergency Liquidity Assistance (ELA) would likely be withdrawn. Without this assistance, the Greek banking system would effectively shut down.
- However, the Greek banking system may need more than the current €89 billion ELA program to stay afloat. Market estimates suggest that the banks can operate for only another week or so with the current facility. The ECB is unlikely to raise this amount until prospects for a bailout agreement improve.
How Would a Greek Exit From the Eurozone Take Place?
- There is no formal mechanism in the European Union treaties to expel a member state, although Greece can unilaterally decide to change its national currency back to the drachma.
- Greece could remain in limbo for some time, with the country technically remaining in the eurozone without a new bailout program or the ELA support, by implementing tight capital controls and using drachmas or IOUs for domestic costs.
What Kind of Contagion Are We Likely to See if Greece Exits the Euro?
- Financial contagion is likely to be on a smaller scale than in the 2012 crisis, for a number of reasons:
- Most exposure to Greek debt is through the official sector. Private sector exposure has been reduced significantly since 2012, from almost 80% of Greece’s total indebtedness to just over 12% today, and is mostly marked to market.
- The international banking system’s exposure to Greece is almost negligible outside of Greek banks. Furthermore, European banks have been recapitalized and stress-tested, and are believed to be more resilient.
- The eurozone in general is in a stronger economic position, including Southern Europe. The periphery economies have adjusted their external and fiscal imbalances over the past few years. They have also carried out a fair amount of structural reform, making them less vulnerable to any contagion.
- However, Greece’s exit could have greater financial, economic and political implications for the eurozone over the long term. The exit of a country from the eurozone would end the crucial notion of the single currency’s irreversibility and markets could react to this “redenomination risk.”
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